Closed-end management companies are similar to open-end management companies in many ways. Both pool investor money and invest it according to the fund’s stated objectives in an effort to earn investment returns. The key difference is how investors buy and sell shares.
Closed-end fund shares trade between investors in the secondary market, not directly with the issuer. When the issuer creates a closed-end management company, it prepares a prospectus and sells shares through an initial public offering (IPO). After the IPO is complete and the issuer has received the proceeds, the shares trade in the secondary market.
Because closed-end fund shares trade in the secondary market, they are negotiable securities. Like most negotiable securities, a fixed (closed-ended) number of shares trades in the market. This is a different type of capitalization than open-end (mutual) funds, which continuously issue and redeem shares and therefore have a changing number of shares outstanding.
During the IPO, the prospectus rule applies. Every purchaser during the IPO must receive a prospectus, which provides detailed information about the issuer and the security being sold. After the IPO, prospectus delivery is no longer required for secondary-market trades.
Closed-end funds don’t have sales charges in the way mutual funds do. Since closed-end fund shares trade in the secondary market, investors pay commissions (similar to stocks and bonds). For exam questions, keep this distinction clear:
Because closed-end funds trade in the secondary market, they can be purchased on margin (using borrowed money) and sold short. Stocks and bonds can also be purchased on margin and sold short, while mutual funds cannot.
Closed-end funds calculate net asset value (NAV) just like mutual funds. In both cases, NAV reflects the value of the assets held in the portfolio. The difference is how NAV is used.
We learned that NAV is the foundational price for a mutual fund in the previous chapter. If a mutual fund has no sales charge, investors buy and sell at NAV. If there is a sales charge, it’s added on top of NAV. In other words, the lowest price a mutual fund can be purchased for is its NAV.
With a closed-end fund, NAV is a reference point, not the transaction price. Since shares trade in the secondary market, the market price moves based on supply and demand. If demand increases, the market price can rise even if NAV doesn’t change. If selling pressure increases, the market price can fall even if NAV doesn’t change.
A helpful way to think about this is to compare NAV to Kelley Blue Book for cars. Kelley Blue Book might list a car’s “book value” at $10,000, but the actual selling price depends on what buyers are willing to pay. NAV works the same way for a closed-end fund: it’s the fund’s “book value,” while the market sets the trading price.
The market price for a closed-end fund can be higher than NAV, lower than NAV, or the same as NAV. Ultimately, supply and demand determine the price.
Interval funds are a unique type of closed-end fund* that share some characteristics of open-end funds. Unlike typical closed-end funds, interval funds do not trade in the secondary market. Instead, investors purchase shares directly from the issuer at NAV. Often, a sales charge is added on top of NAV.
*Although interval funds operate in many ways like open-end funds, they are legally structured as closed-end management companies. Don’t get stuck on the legal details - focus on which category of investment company they fall into.
Investors can redeem shares later, but only at specific times called “intervals.” These redemptions occur through a repurchase offer. Most interval funds allow redemptions monthly, quarterly, semi-annually, or annually. For example, if an interval fund offers quarterly redemptions, investors can redeem shares only four times per year. Outside those windows, investors generally can’t liquidate their shares.
Interval fund managers also limit how many shares they will redeem during each repurchase period. In most cases, the fund won’t allow more than 25% of outstanding shares to be redeemed at any repurchase offer. If investors request more redemptions than the fund is willing to repurchase, the fund typically allocates redemptions on a pro-rata basis.
For example, suppose two investors each request to redeem 10 shares (20 total), but the fund will repurchase only 16 shares. Each investor would be allowed to redeem 8 shares.
Because of this structure, interval funds are known for liquidity risk. They may be unsuitable for investors who need quick access to their money. Many interval funds also charge redemption fees (repurchase fees) of up to 2%. Rules and regulations don’t allow redemption fees above this amount.
Sales charges and redemption fees aren’t the only cost concerns. Interval funds are also known for high expense ratios (often due to significant management fees) and 12b-1 fees. Bottom line: investors can face multiple layers of costs when investing in interval funds.
Given the risks and costs, why might an investor consider an interval fund? The limited redemption feature can give the fund manager more flexibility. Instead of managing daily redemptions (as open-end fund managers do) or worrying about investors selling shares in the market (as typical closed-end fund managers do), interval fund managers can count on investor money staying in the fund for at least some period of time. That stability can allow the manager to invest in less liquid, higher-risk investments that may offer higher yields. As always, the investor must weigh potential returns against the fund’s costs and risks to decide whether it fits the portfolio.
If you’re curious and want to study a few real-world versions of this type of fund, check out Pimco interval funds.
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